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My Forbes colleague Rick Ungar has caused a stir by arguing that medical loss ratio regulations contained in Obamacare have put us “on an inescapable path to a single-payer system for most Americans and thank goodness for it.” Rick’s glee at this alleged development is interesting. However, the bottom line is that Obamacare’s MLR regulations won’t deliver us a utopia of government-run single-payer health care. Instead, they will usher in a new era of private insurance monopolies and significantly drive up the cost of health insurance, things that neither liberals nor conservatives should cheer.

What is a medical loss ratio?

Investors in managed care stocks have long used medical loss ratios, or MLRs to understand the economic health of insurers. Insurers collect premiums from their beneficiaries, and then spend money paying out claims for health care expenses on behalf of those beneficiaries. The medical loss ratio is the percentage of premiums paid out in health expenses. So, if an insurer has had a bad year, in which expenses were greater than premiums collected, MLR can be higher than 100 percent. On average, depending on the type of insurance, MLRs are in the range of 70 to 85 percent.

So does that mean insurers are highly profitable? No. 2010 profit margins for publicly-traded health insurers averaged 4 percent. This compares poorly to cigarette manufacturers (20%), railroads (15%), long-distance carriers (14%), and soft-drink manufacturers (13%). Insurers need to employ people who make sure that they don’t get victimized by fraudulent or inappropriate claims. It’s worth noting that, for all the ignorant rhetoric about Medicare’s supposed efficiencies, the Government Accountability Office has estimated that Medicare fraud amounts to four times the profits of the entire private insurance industry. In contrast, the key administrative cost for insurers is ensuring that your premium dollars are spent wisely, helping to keep premiums down.

Factors that affect medical loss ratios

So, now that you understand that MLR is simply the ratio of premiums collected to health-care claims paid, what makes the MLR of a particular insurance plan go up or down? There are three key factors to consider.

The first is the membership of the plan. A pool of younger, healthier people is going to require less health-care expenditures than one of older, sicker people. In practice, what typically happens is that younger, newer plans tend to enroll younger, healthier people, whereas older, established plans have a larger mix of older people. Hence older, established plans have more medical costs.

The second is the size of the plan. As with most businesses, there are economies of scale in the insurance industry. Plans that cater to individuals buying insurance on their own tend to be smaller, and less efficient, than plans that cater to large corporations. In 2010, among the top six for-profit insurers, MLRs in the individual market were around 73%; MLRs for companies with 50 or fewer employees were around 79% (the “small group market”); MLRs for companies with more than 50 employees were around 82% (the “large group market”). As you can see, plans serving larger institutions have greater efficiencies in how they spend premium dollars.

The third is the price of the plan. Many states force insurers to charge lower prices to older individuals, and higher prices to younger individuals, in a system called community rating. Obamacare contains such a provision; it mandates that insurers are only allowed to charge a maximum of three times for an older policyholder what they charge for a younger policy holder. That is to say, for the same plan, insurers can charge a 64-year-old only 3 times what they charge an 18-year-old, even if the 64-year-old’s health expenses are 50 times those of the 18-year-old. If you want to know why a lot of young, health people opt out of the health insurance market, this is why: young people are forced by law to subsidize the care of older people, even though young people have lower incomes and poorer employment prospects.

How Obamacare’s MLR mandate will harm small businesses and the self-employed, and create private monopolies

How do these three concepts fit together? Here’s how. If you’re an upstart insurer trying to break into an existing market, your plans are likely to enroll younger, healthier people, because you’re likely catering to younger businesses and individuals. However, because of community rating requirements, you’re forced to charge more for your plans—relative to the medical costs incurred—than your established competitor, who has a more "favorable" mix of younger and older beneficiaries. That means that your medical loss ratios in a newer plan are going to be lower, and run afoul of Obamacare’s one-size-fits-all MLR mandate.

That mandate, contained in Section 2718 of the Patient Protection and Affordable Care Act, requires that MLRs in the individual and small-group markets exceed 80%, and 85% in the large-group market. As I noted above, most insurers will be able to reach the targets for the large-group market. Some will, and some won't, be able to handle the targets in the small-group market. However, the individual market—the market that serves vulnerable people who are unemployed, or freelancing, or starting their own businesses—is the one that is on the verge of collapse.

This doesn't mean that the private insurance market as a whole will collapse. Of the 194.5 million Americans with private insurance, 10.3 million get it in the individual market (5.3%), and 18 million get it through the small-group market (9.3%), according to a study by Paul Houchens of Milliman. But that's still 28 million people whose health coverage is now less secure.

I first wrote about this problem in May of 2010, describing it as a “hidden time bomb,” warning that private insurers “may decide to exit the [individual-insurance market] altogether” because there isn’t much room to improve MLRs in the individual market. And, sadly, I was right. has announced it is withdrawing from the individual markets in Indiana, Colorado, and other states. Other insurers have similarly withdrawn from Minnesota, Texas, Virginia, and Illinois. I won’t bore you with a laundry list of further examples.

And it’s not just insurers who are dropping out. In September of 2010, McDonald’s announced that, without a waiver from the MLR regulations, the company would be forced to drop health coverage for 29,500 hourly-wage employees. (After the ensuing media firestorm, HHS granted the waiver.)

This is why at least 16 states have applied for waivers to the MLR regulations: Maine (approved); New Hampshire, Nevada, Kentucky, and Iowa (partially approved); North Dakota and Delaware (rejected); and Florida, Georgia, Louisiana, Kansas, Indiana, Michigan, Texas, North Carolina, and Oklahoma (under review). State governments understand that Obamacare’s MLR regulations will force most insurers to stop offering coverage to people who aren’t in the employer-sponsored system: the very people in whose name the law was passed.

The MLR rules force insurers to hike premiums

Since many of the administrative costs in health insurance are hard to cut out—costs like fraud prevention—insurers will be forced to resort to another option to meet Obamacare’s MLR mandates: premium hikes.

Think of it this way: let’s say you’re charging $10,000 for a health plan, and have $7,000 of health costs associated with that plan (and $3,000 of administrative costs), for an MLR of 70 percent. If you want to increase your MLR to 80%, there are two ways to do it. First, you can cut administrative costs and premiums (if administrative costs were $1,750, and premiums $8,750, $7,000 of health costs would equal an 80% MLR). Second, you can keep your administrative costs the same ($3,000 per person), and find ways to spend more money on health-care, passing on the costs in the form of premium hikes ($15,000 in premiums, and $12,000 in health expenses, would also yield an MLR of 80%).

To put this another way: if an insurer is forced to choose between cutting administrative costs by 42 percent, or not firing its employees and instead hiking premiums by 50 percent, which is it going to choose? After all the fat is trimmed, the insurer is going to choose to increase premiums, and increase them significantly. It will spend money on wasteful health expenditures, the kind that liberal health wonks are always complaining about, just to meet an arbitrary MLR target.

The largest private insurers will survive the MLR regulations

As I mentioned above, smaller plans will get squeezed, because they won’t be able to take advantage of economies of scale, nor of a more “favorable” mix of enrollees. Larger plans will be just fine. Carl McDonald of , an HMO analyst who has done the most detailed work on medical loss ratios, estimates that Obamacare’s mandated rebates will cost the six biggest insurers about 1.4 percent of premiums collected.

In 2010, McDonald estimated that “the average commercial plan could see its earnings negatively impacted by 5-6% (relative to the current consensus outlook)” in 2011: an annoyance, but hardly catastrophic. As Sarah Kliff notes here, professional managed care investors are quite aware of the MLR regulations, and yet the HMO stocks have been on fire. The market isn’t always right, but if Rick knows something that the market doesn’t, he should put his money where his mouth is, and massively short the managed care sector.

Obamacare’s MLR mandates will make health care more expensive, and harm those who are most in need of health coverage. Those who think that this is a good thing have revealed something about themselves.

PROGRAMMING NOTE: I will be blogging relatively infrequently in the month of December, due to work and holiday-related obligations. Please follow my Twitter or RSS feeds, or subscribe to my weekly e-mail digest, to keep abreast of my blogging activity.

UPDATE 1: A previous version of this article incorrectly listed Empire Blue Cross Blue Shield as withdrawing from the New York individual market. Empire is instead cutting back on products in the small-group market, but not completely withdrawing from any of the commercial markets in New York.

UPDATE 2: Grace-Marie Turner of the Galen Institute has published a comprehensive list of published accounts of private insurers exiting the market, primarily in the individual and small-group segments.